Hidden Opportunities in Stress Tests? Or More Pain?

WASHINGTON, DC-The Treasury Department is expected to release the results of the stress tests it performed on the 19 top banks Thursday morning. The signals about the results have been mixed, ranging from banks seeking more time before their results are released to reassurances from Secretary of the Treasury Timothy Geithner that none of the 19 are insolvent.

The consensus is that the results – no matter how well presented they may be initially, at least for the top 19 – will eventually result in decreased lending for commercial real estate projects. “This is going to compound an already difficult situation given the absence of traditional debt financing,” Mike Goldsmith, the head of the commercial real estate group of BBK, an international business consulting firm, tells GlobeSt.com.

Real estate loans will be one of the weakest links in the largest banks portfolios, he predicts. Perhaps more importantly they will be a disproportionate burden for smaller and medium sized institutions, he says. “The results – and subsequent actions by the regulatory authorities – are going to dampen whatever modest desire these banks have to provide financing.”

There is a silver lining, albeit a small one, and one only possible for the craftiest of investors: many of these banks will conclude they have no other choice than to dispose of their assets if they are found to have inadequate capital, Kamal Mustafa, head of Invictus, a New York City-based company that provides consulting on stress tests and other banking issues, tells GlobeSt.com. Banks thus far have shown little inclination to let assets go at distressed prices. But there are several reasons why they very well might now, largely because the options open to them are more unpalatable.

If deemed to have inadequate capital, the banks will either sell off assets, thus reducing the need for capital. Raising capital, of course, is another option, but one unlikely in this current market, Mustafa says: bank equity prices are so depressed that raising funds by issuing stock will be extremely expensive. Another, equally unpalatable option, is a capital injection under TARP. Accompanying that, though, are limits on executive compensation and other requirements.

There will not be a lot of low-hanging fruit for hungry distressed asset investors, Mustafa says. Investors will have to walk a very fine line between what the banks need to boost capital reserves and what they think the assets are worth.

Banks cannot allow their assets to be traded at too low of a price, no matter how dire the situation, he continues. “To give you a simplified example, for every $100 in assets a bank sells, it may free up $3 in capital. So discounting anything greater than, say, by 10% defeats the purpose.”

Investors are also leery of doing business with the US government. Although they are not subject to rules on executive compensation, it is clear that the government is still feeling its way through this crisis with no map by which to navigate. Simply put, the Treasury Department has announced financial rescue programs only to shift their goals months later.

For instance, earlier this year FASB relaxed the mark to market accounting standards. These standards, which are loathed in many quarters, were forcing banks and other holders of real estate paper to write down these assets to their market price, even if there was no market. “It is another confusion signal, especially considering the emphasis on stress test results now,” Goldberg says. “The change in the accounting regs suggested these institutions could ignore the markets” when there was no activity. “On the other hand we have distressed tests that are causing different metric to be applied.”

GlobeSt.com will update this story as the stress test results are released.